Municipal bonds are the primary financial instrument utilized by California school and community college districts to finance their capital projects and modernize their aging facilities and infrastructure. However, general obligation bonds issued by these districts may vary greatly from one another. Each district has unique needs and often find themselves in varying economic situation. This creates a wide variance in the structure and terms of municipal bonds issued in California. This diversity reflects the complex financial strategies employed by California school and community college districts to meet their funding requirements while navigating economic challenges. Tony Hsieh of Keygent LLC discusses the various factors that California school and community college districts should consider when structuring and issuing their municipal bonds.
What is the Primary Purpose of the Municipal Bonds?
First and foremost, a California school or community college district needs to determine what is the purpose of issuing their municipal bonds. Will it be used towards capital projects or to refund outstanding municipal bonds or other debt? In some instances, districts can elect to issue bonds that will be used towards funding projects in addition to refunding outstanding debt such as certificates of participation. Tony Hsieh of Keygent notes, “Districts should confirm with their bond counsel when using general obligation bonds to refund outstanding debt to ensure legality based on the original project list.”
Interest Rates: A Critical Consideration When Structuring Municipal Bonds
Tony Hsieh of Keygent LLC explains, “Interest rates for municipal bonds are one of the most important considerations when structuring municipal bonds. Current and future interest rates can impact long-term debt plans.” The interest rates California school and community college districts receive for their bonds may vary based on several factors, including market conditions, the creditworthiness of the issuing district, and the type of bonds. Generally, school districts with higher credit ratings may receive lower interest rates, reflecting lower perceived risk from investors. Conversely, districts with lower credit ratings may need to offer higher interest rates to attract investors. Additionally, the interest rate environment at the time of issuance has a significant role in determining the final interest rate districts receive for their bonds. Higher interest rates generally will result in higher tax rates leaving less tax rate capacity for future financings and lower interest rates generally will result in lower tax rates leaving more tax rate capacity. Many of the following structuring considerations have an impact on the interest rates districts will receive for their municipal bonds.
Keygent LLC Discusses Tax-Exempt & Taxable Bonds
In California, school districts have the option to issue both taxable and tax-exempt municipal bonds to finance capital projects and renovations or to refund outstanding debt. Tax-exempt bonds provide investors with interest income that is exempt from federal and state income taxes, while taxable bonds are not exempt. Tax-exempt bonds typically have lower interest rates than taxable bonds since investors are generally more willing to accept lower interest rates for the benefit of receiving tax-exempt interest earnings. Typically, municipal bonds issued for capital projects and renovation of aging facilities will be issued as tax-exempt bonds. Tax-exempt municipal bonds that financing capital projects and modernization that are issued as tax-exempt have specific IRS spend-down requirements of bond proceeds to maintain their tax-exempt status. Refunding bonds may also be issued as tax-exempt, but if the bonds that are being refunded are done so on an advanced basis, 90 days prior to their first optional redemption date, the refunding bonds can only be issued as taxable.
Keygent Explains the Difference Between Current Interest & Capital Appreciation Bonds
Current interest bonds pay periodic interest to investors throughout the term of the municipal bond, typically on a semi-annual basis, until the bond matures. Capital appreciation bonds (“CABs”), on the other hand, do not pay periodic interest. Instead, the interest is deferred until the final maturity date of the bonds, with the deferred interest compounding until maturity. Typically, CABs will have higher interest rates than current interest bonds because investors will demand higher interest rates in lieu of receiving semi-annual interest payments. California school and community college districts may elect to utilize CABs in their general obligation bond issuances to help manage their projected tax rates. By eliminating some or all interest payments in earlier years, the additional tax rate in earlier years is also reduced or eliminated. Districts may need to opt for this structure if they lack tax rate capacity in earlier years. By deferring interest payments, districts can generate proceeds for necessary projects while maintaining their tax rate promise to voters. However, utilizing capital appreciations bonds may result in an overall higher borrowing cost for the issuing district.
Financing Term Length: How Long Until Your Municipal Bonds Mature?
The financing term (length of municipal bonds) significantly influences overall cost. Typically, municipal bonds are issued with a financing term that best manages tax rate capacity for future issuances. Short term bonds usually have a lower overall borrowing cost while long term bonds typically have higher overall borrowing costs. However, a shorter financing term for municipal bonds often results in higher annual debt service payments to repay the principal and interest within a condensed timeframe. In contrast, extending the financing term distributes the repayment over a longer period, reducing the annual debt service burden. By creating higher yearly obligations, a district may significantly strain their tax rate capacity, leaving less room within their annual tax rate for future issuances. Utilizing a longer financing term can provide a district with greater tax rate capacity, maintaining their flexibility for future issuances. Essentially, a longer financing term offers more flexibility in tax rate management, facilitating a balance between meeting current financial obligations and planning for future issuances. Tony Hsieh of Keygent LLC noted, “Determining the financing term for a bond issuance is a careful balance between managing a district’s tax rate and the overall borrowing cost of the bonds.” In California, municipal bonds can have a maximum financing term of forty years. Assembly Bill 182 (“AB 182”) set a maximum financing term of twenty-five years for CABs but current interest bonds may still have a maximum term of forty years.
Keygent: Determining How to Allocate Principal
Once the financing term had been determined, the next step is determining how to amortize the principal for the municipal bond issuance. Amortization is the process of determining the scheduled payments over the life of the bond. This allows a school or community college district to repay the principal amount spread out over several years rather than in one payment on the final maturity date of the bonds. Principal is typically spread out over the financing term. With the interest that is generated, a district can target a debt service schedule with a particular tax rate target in mind. The tax rate target is typically determined by the amount of future issuances a school or community college district is planning to issue and the amount voters have approved.
Additionally, principal can be amortized as serial bonds and term bonds. Serial bonds are bonds issued with different maturity dates and typically with different interest rates. Typically interest rates that are further from the issuance date will be higher. Term bonds are bonds issued with the same maturity date and interest rate. Typically, term bonds will have sinking fund payment dates, where principal payments are made and set aside to pay the term bond upon its final maturity date. Generally, the use of serial bonds or term bonds is determined by investor demand.
Keygent LLC Discusses Optional Redemption Dates
Another consideration is the optional redemption provision for the general obligation bond issuance. An optional redemption date is a provision that allows the issuing district the ability to call back the bonds ahead of their scheduled maturity date. This provision provides a California school or community college district with the flexibility to take advantage of a lower interest rate environment and save the district taxpayers’ money. However, investors will typically demand higher interest rates to compensate for the added risk of their bonds being called prior to the maturity date. Generally, municipal bonds have an optional redemption date of ten years following the issuance of the bonds, but many districts have elected for an earlier optional redemption date to allow for future potential refinancings. In California, if municipal bonds utilize capital appreciation bonds, the CABs must have an optional redemption of ten years from the issuance date per AB 182.
Keygent Explains Premium & Discount Bonds
In the municipal bond market, the terms “premium” and “discount” are used to describe the price of a bond in relation to its par value, which is typically set at $1,000 per bond. A municipal bond sells at a premium when its price exceeds its par value. This situation often occurs when the bond’s interest rate is higher than the current market rate yield, making it more attractive to investors seeking higher cashflow. As a result, investors are willing to pay more than the bond’s face value for this benefit. Conversely, a municipal bond sells at a discount when its price is below its par value. This usually happens when the bond’s interest rate is lower than the prevailing market rate yields. Some investors find this less attractive since it offers a lower ongoing cashflow. Investors, therefore, will pay less than the face value of the bond to compensate for the lower interest payments received. If a municipal bond’s coupon is equal to its yield, it is referred to as a “par” bond. The generation of premium and discount typically generates bond proceeds that are not equal to the par amount of the bonds. If the bonds generate more premium than discounts, there will be excess bond proceeds, and if there is more discount than premium, there will be fewer proceeds. California school or community college districts typically consider generating premium for a capitalized interest fund, which is used to cover interest payments in the first few years, or to pay costs of issuance and underwriter’s discount. Although California school and community college districts may still generate premium to pay costs of issuance and underwriting fees, the California Attorney General recently published an opinion that premium should only be generated for capitalized interest.
Tying It All Together
When planning municipal bond issuances, considering the possibility of future issuances is crucial. Anticipating future borrowing needs, including timing, allows school and community college districts to structure current debt in a manner that avoids overburdening future tax rates. Through the use of various structuring considerations mentioned previously, districts can manage their tax rate to align with their future municipal bond issuances. By carefully timing and structuring their debt issuances, districts can ensure they can meet their project needs while maintaining their tax rate promise to their voters.
Ultimately, the structuring of municipal bonds is a complex process that requires a delicate balance of multiple considerations to ensure the lowest overall cost of borrowing while maintaining the flexibility to issue future municipal bonds. Structuring municipal bonds requires careful consideration of various factors such as estimating the current and future interest rate environment and determining the financing term length and amortization schedule to meet the financial goals of the issuing school or community college district. Working with a municipal advisor can provide valuable guidance on how to structure a bond issuance that meets the districts goals while maintaining flexibility for future issuances. Their expertise not only helps in navigating the intricate process of bond structuring but also in identifying opportunities to optimize the municipal bond’s terms for the benefit of the district. In the complex and evolving landscape of municipal finance, being mindful of all considerations when structuring municipal bonds is paramount, as it ensures the issuance is strategically aligned with both the financial objectives of the districts and the expectations of their communities.
Keygent LLC is a municipal advisor firm based in El Segundo, California that provides strategic and technical municipal advisory services solely to California school and community college districts. If you would like to learn more or to speak with one of their public financing professionals, please visit www.keygentcorp.com.
